Royalty math 'not adding up'!

I work with the Small Explorers & Producers Association of Canada with about 450 mostly junior oil and gas companies in our membership. I hope the following illustration of the cost and return on investment climate in Alberta's petroleum sector in 2008 will help.

Think of the oil & gas industry as being in the land development business. The developer buys land (petroleum and natural gas leases) and then 'develops' this land through capital investment in drilling, building pipelines, roads, compressor stations, sour gas plants, etc. Then they sell off a portion of their developed land base every year (by selling the produced petroleum or gas).

Each year the developer's asset base is smaller and his company is therefore smaller than it was the year before unless he goes out each year and buys more land (at today's prices) and drills and builds roads and pipelines, etc. also at today's prices.

If you were a real estate developer who bought your development land around Calgary in the 1960s or 70s or 80s or even the 90s it was cheap compared to today. The developer got his land cheap and let's say he also serviced the land 20 years ago through investing in the basic roads, sewer, water, power, etc. And today he is still selling the last of those developed/serviced lots to new Calgarians but getting 2008 Calgary lot prices.

Wow!! This developer's profits would be very high and people and the media might even be pointing to 'record' profits or 'windfall' profits, etc. These are his 'legacy' profits but they won't last forever.

Even with your record 'legacy' profits what are you going to do with those profits? You want to stay in the land development business because it's all you know how to do.

So you have to acquire more land and you have to pay today's high prices and you must develop it at today's high costs for labour and materials, but...you can only sell the new house lots at today's prices too so your profits from the newly acquired and developed lots are much, much smaller than the 'legacy' land you are still selling off too.

This is the situation of most of the large oil and gas companies: Imperial, Husky, PetroCanada, Encana (the latter also enjoys a huge Alberta royalty free land base courtesy of Canadian Pacific Railway).

They have a large 'legacy' land and asset base acquired and built when costs were much cheaper than today. The huge profits they are reporting have a huge contribution from their 'legacy' asset base. To illustrate the impact of this favored 'legacy' asset base consider the world of the junior sector (my members).

Most active juniors are less than ten years old; some only 5 years old or less. Thus they have no 'legacy' asset base: they acquired their land (petroleum and gas leases) at high prices in the last few years and must develop it at today's sky high costs for labour, materials and services.

In the last quarter of 2007 the junior sector (public companies) had 70% reporting losses even as they collectively paid hundreds of millions of dollars in royalties to the Alberta government.

This is a better picture of the investment attractiveness in Alberta in today's world of high costs.

The large companies will want to invest their profits somewhere. Alberta? Where the government's new royalties will push an already high cost basin out of the North American market for its energy products.

Just look at the junior sector's return on investment. Not terribly attractive is it?

Why does $1.4 billion royalty take (which seems relatively small) have such an outsize impact on investment attractiveness?

Consider this: just 5% of Alberta's gas wells pay over 60% of the natural gas royalties and just 5% of the conventional oil wells also pays about 60% of the oil royalties (Tristone Capital reported this amazing stat in October).

While the $1.4 billion seems relatively small it will largely be recovered from this very small number of wells where royalties will be going up by 40%, 50% or even 60%.

These wells cannot afford this extra burden since these highly successful wells may only be found in perhaps 1 in 10 drilling attempts.

These terrific but few in number wells provide the cash flow the producers need to recover the cost of their dry holes and their other costs . These few wells cannot carry the company's own cash flow needs and the government's own outsize appetite to capture more royalties yet that is what the new Royalty Framework attempts to do.

That is why the big guys, with all their huge profits, are at the same time cutting back on future investment in Alberta. They know future investment in Alberta won't enjoy the fat 'legacy' profits and they have to find a better place than Alberta to invest.

The junior sector drills over half of Alberta's new exploration target wells (since the big guys don't find much left in Alberta worth exploring for) can't raise the capital they need to keep this going. The investors in the juniors can do the royalty math and don't see any return on investment that justifies the risk.

I hope this helps. Albertan's truly don't yet understand what the Stelmach government has done.